Sale of Vacation Home Rental

Technical topics regarding tax preparation.
#1
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my client had a rental in Hawaii that he used both for vacation and a rental. the property never made much money. each year his income from the rental was offset by the expenses of having the property over there. he sold it in 2017. over the years the tax program took an enormous amount of depreciation that was never used because of the income limitations related to the subject property. he sold the asset in the up swing of the real estate economy and therefore there is gain. my question is whether the depreciation never taken (not allowable because of income limitations) does that depreciation reduce the basis of the property? can the unused depreciation and suspended losses related to the property be applied to this transaction in the year of disposition?
 

#2
philly  
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According to IRS Publication 946: A basis adjustment must reduce the basis of the property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation actually deducted when filing your taxes.Depreciation allowable is depreciation you’re entitled to deduct, but didn’t necessarily deduct for tax purposes.

If you do not claim depreciation you’re entitled to deduct, you must still reduce the property’s basis by the full amount of allowable depreciation
 

#3
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yes, I got that. My confusion here is since the depreciation was never taken due to income limitations, was the depreciation allowable?

Look at the facts here: 750k in allowable depreciation, but never taken
Sold the asset: 2.4 million, now the basis is being reduced by 750k and it is also involving recapture.

this was a vacation rental, not one penny of deductions over the years. But I do agree, a significant amount of rental income never taxed.
 

#4
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You say "not allowable because of income limitations"...
What were the "income limitations" and how did they limit the amount of depreciation that was allowed?
 

#5
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the depreciation taken was limited by the amount of rental income on the property. it seems that my program calculated depreciation that would have been applicable to the property as if it was a rental all year instead of the fraction of the year that is the case. I am inclined to figure allowable depreciation based on the percentage of time that the asset was actually rented in a year.
 

#6
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Did your program happen to mention IRC Section 280A?
 

#7
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I am reading IRC 280A.

What interest me about allowable depreciation on sale is the following: is there a depreciation adjustment for the depreciation not taken although it was allowable? Another words, you may have 750k in allowable depreciation, but because expenses are limited to the extent you have income on the property say 100k in depreciation was actually taken. Does this mean that there is a depreciation adjustment adding back to basis of 650k? I am inclined to think that something like this is permissible.
 

#8
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"[I]s there a depreciation adjustment for the depreciation not taken although it was allowable?"

Here's IRS's version of an answer to what they think your question is:
Decrease the basis of property by the depreciation you deducted, or could have deducted, on your tax returns under the method of depreciation you chose. If you took less depreciation than you could have under the method chosen, decrease the basis by the amount you could have taken under that method. If you did not take a depreciation deduction, reduce the basis by the full amount of the depreciation you could have taken.

.....

If you deducted more depreciation than you should have, decrease your basis by the amount equal to the depreciation you should have deducted plus the part of the excess depreciation you deducted that actually reduced your tax liability for the year.

In decreasing your basis for depreciation, take into account the amount deducted on your tax returns as depreciation and any depreciation capitalized under the uniform capitalization rules.

We also recommend that you read IRC Sections 1016 and 1245 (or is it 1250?) for even more layers of complication.
 

#9
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It sounds like may be your software computed the depreciation applied and it to the rental and the resulting loss was disallowed. And if that was the case, the passive loss carryover should be allowed as a result of the sale. But that is me making the assumption that your software is not broken and did what it was supposed to.
Because on T.A. ten was the most you were allowed
 

#10
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But first, we should read IRC Section 469(j)(10) which (I think) says that if Section 280A(c)(5) [vacation home rules] applies to limit rental deductions, then the passive loss rules of Section 469 don't apply.
 

#11
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Just in the interests of Tax Justice, I do not believe that depreciation expense that was never actually allowed to be deducted should reduce basis. However, I have never seen a Tax Court case or Treas Reg specifically on point for vacation homes.
 

#12
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I understand that, Spell. But I am still assuming that his software is not broken and only included the allowable depreciation in the calculations and that his concern is over all of the suspended losses (largely made up of depreciation) that were not claimed in the years they originated in. And he may not be seeing the fact that those losses are now being allowed.

Confession: I left public accounting to work at one of the major tax software providers so now I have become doubtful of claims that "my program calculated" ... especially when the speaker appears not to have noticed the discrepancy year after year after year.
Because on T.A. ten was the most you were allowed
 

#13
Doug M  
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I agree TM, especially if the carryovers are related to taxpayer using property for more than 14 days personally.

There is a pecking order to reach no gain from rental activity when personal use exceeds 14 days.

1. Interest/prop tax/casualty losses/direct expenses
2. Operating expenses (util/maint)
3. Depreciation

Many times it never gets to the third layer. But, if the software is accumulating correctly, the suspended losses should include this depreciation expense. So, if you are receiving a benefit of the freed up suspended losses due to the sale, the basis should remain unchanged.

I do note that the IRS worksheet (5-1 pub 527) has the carryover broken out between operating expenses carried over and depreciation carried over. So there must be a reason.
 

#14
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I am using Lacerte Individual Tax Program, a good program.

I understand that Vacation Rental Property is treated as "personal" and that no losses or expenses carried forward are deductible against ordinary income in a fully taxable disposition to an unrelated third party.

We have a break even with respect to the net rental income in the year of disposition.

your right about the pecking order and the taxpayer never reached the depreciation being deducted for all years since 2004.

he sold the property now for 2.4 million and has a cost basis in the property of 2.3 million. After selling costs we are talking peanuts for a gain.

The program has carried forward 801k in allowable depreciation from all prior years.

Do I have an 800k gain? It was depreciated under 27.5 straight line, so no recapture.

I have a great deal of difficulty finding anything specific and on point.

At the end of the day, I have 1.2 million in expenses including depreciation carried forward that is not deductible.

But is the unused, but conceivably allowable depreciation now representing a gain on a property otherwise sold at breakeven?

I saw the depreciation accumulating year after year, but ignored it do to it not having any effect on the tax year at issue.
 

#15
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I do note that the IRS worksheet (5-1 pub 527) has the carryover broken out between operating expenses carried over and depreciation carried over. So there must be a reason.


And the reason is because they’re separate buckets, as you note. And any 280A carryover involving depreciation is treated as depreciation that was not allowed, so no basis reduction.
 

#16
dave829  
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I’m confused. I can’t tell from this discussion whether the “income limitations” that OP is referring to are the limitations under 280A or 469. As Spell Czech points out in #10, 280A take precedence over 469, so let’s look at 280A first.

Assuming that this was a rented-out vacation home with personal use each year more than the permitted amount (14 days/10%), and that 280A applies, then 280A(c)(5) limits the allocable rental deductions to income. Any depreciation that’s included in the allowed rental deductions is considered “allowable” under 1016. Any depreciation that exceeds the limit is not, and under 280A(c)(5), it doesn’t carry over to the next year although it carries over to the next year, it might never be allowable if there isn't enough rental income to absorb it before the vacation home is sold.

If, instead, the “income limitations” refers to 469, then the depreciation becomes part of the passive loss carryover from year to year and is released (allowed) in the year that the property is sold. This would then be “allowable” depreciation under 1016.
Last edited by dave829 on 16-Aug-2018 10:43am, edited 1 time in total.
 

#17
makbo  
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dave829 wrote:I’m confused. [...]and that 280A applies, then 280(c)(5) limits the allocable rental deductions to income. Any depreciation that’s included in the allowed rental deductions is considered “allowable” under 1016. Any depreciation that exceeds the limit is not, and under 280(c)(5), it doesn’t carry over to the next year.

I'm confused too, I assume you mean 280A and not 280 in your cites above?

Sec 280A(c)(5) seems to say the exact opposite of what you assert when you say it "doesn’t carry over to the next year.".

§280A(c)(5): "Any amount not allowable as a deduction under this chapter by reason of the preceding sentence shall be taken into account as a deduction (allocable to such use) under this chapter for the succeeding taxable year."

I believe OP is talking about rental loss limitations due to use as a personal residence, not passive losses. The question is whether, similar to passive losses, the carryforward of unused expenses, including depreciation, is allowed in the year of disposition. If yes, then depreciation will have been allowed, if not, then it was never allowable.
 

#18
dave829  
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Thanks for being an "eagle eye." I edited my post.
 

#19
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"Just in the interests of Tax Justice," says TaxMonkey, in #11 above, "I do not believe that depreciation expense that was never actually allowed to be deducted should reduce basis."

The IRS's "rule" is that depreciation, allowed or allowable, whichever is greater, reduces basis, n'est-ce pas? If more was allowable than the amount that was actually taken ["allowed"] then the greater amount, which includes some depreciation that wasn't allowed, is supposed to reduce tax basis, according to the IRS rule, as I understand it.

If you didn't take all that you were allowed to take, you're treated as if you had!!! <<That's what the IRS says...
 

#20
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okay, the bottom line looks like this to me:

A vacation rental is treated for tax purposes as a second home, i.e. personal. Upon disposition to a third party there is no realization of suspended and carried forward losses.

Depreciation that was allowable, but never used due to income limitations and because of where it is in the descending pecking order, does reduce basis of the vacation property when it comes to calculating capital gains.

it seems to me, that even though this taxpayer never took one penny of depreciation against his property, that his basis is reduced by $800000. does this seem logical and right to you?
 

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